Businesses need to understand all of their different expenses, and the costs associated with loans are no different. It’s vital you fully understand all of them, especially interest, before making a financial commitment to a business loan. Here’s what you need to know:
Different Types of Business Loan Costs
The majority of the cost of any business loan comes in the form of interest. Interest is how lenders make a profit; for every pound they lend out, they receive an extra percentage back. This extra percentage is known as the interest rate, and depends on a number of factors.
Interest costs are not the only ones you need to know about though; business loans can also charge a variety of loan fees. These fees can sometimes add up to thousands of pounds, and differ a lot between lenders and types of business financing.
Understanding Interest Rates
The amount of money a business borrows from a lender is known as the principal. Interest is charged on the principal; for example, if you borrow £1,000 and are charged 6% interest per year, then after one year, you would need to have repaid the original £1,000 plus 6% of £1,000, which is £60. So the total repayment amount totals £1,060.
This is how interest works in a very basic way, but the majority of loans require a bit more thought, because interest accrues. Think of it this way: if we take the above example, but instead of repaying the £1,000 loan over one year, you repay it over ten years. You are charged 6% interest per year that you have the loan, but the interest charge itself gathers interest. So in year two, you’re paying interest on £1,060 – which is £63.60. So the total repayment amount becomes £1,060 + £63.60 = £1,123.60. In year three, you’re paying interest on £1,123.60, which is £67.42. And so on. This is why longer term loans cost more in interest than shorter term loans with the same interest rate.
The variables that affect the overall cost of a business loan are therefore: the principal, the interest rate, and the loan term. With these three numbers, you can calculate the overall cost of a loan. If you know your repayment frequency, you can also calculate your individual loan repayment costs. There are dozens of free loan calculators available online to help you do just this.
Factors That Affect Business Loan Interest Rates
The next big question is: what interest rate will you be charged for a business loan? There are a number of factors that affect this:
- The Bank of England base rate (which is reviewed eight times per year and can go up or down depending on a range of national and international economic factors)
- The state of the loans market and competition/risk appetite among lenders
- Each individual lender’s profit margin (which is why different lenders often charge the same borrower different rates)
- The type of business loan (for example, secured loans are considered less risky by lenders, and so usually have lower interest rates than unsecured loans)
- The length of the loan term (generally, longer term loans have lower interest rates than shorter term loans, but because of cumulative interest, this does not necessarily mean they are cheaper overall)
- Borrower-specific characteristics, including:
- Business credit score
- Business age
- Business income
- Business assets
- Industry the business operates in
As you can see, some of the factors that affect interest rates are very general, while others are specific to each individual business. Businesses with preferable characteristics (e.g. good credit, high income, etc.) are considered safer to lend to, and so are able to access lower interest rates than businesses that are considered riskier. This is another reason why shopping around for the best deal on a business loan can make such a difference to your overall cost – different lenders use different metrics to assess potential borrowers’ riskiness.
Fixed Rates vs. Variable Rates
Lastly, we need to mention that not all rates work in the same way. There are two major categories of rates: fixed rates, and variable rates. Fixed rates stay the same over the term of the loan (or, sometimes, for very long-term loans, they are fixed for a set number of years before changing). Variable rates do not; they can fluctuate depending on the market. This makes variable rates less predictable and less stable, but potentially lower than fixed rates (depending on economic conditions).
All rates, whether fixed or variable, should be considered and compared using the same metric: annual percentage rate, or APR. The APR is the average rate over a year. Because some loan products advertise low introductory rates, changing rates, or have hidden fees and extra costs, it’s not always possible to compare them without a standardised metric. The APR is this metric; it includes all interest and standard fees and makes it into an annual figure, allowing you to appreciate a loan’s true cost and how different loans stack up against each other.
Understanding Loan Fees
The APR of a loan will include some loan fees, but not all. And because some loans charge fees and others do not, it’s worth understanding how this aspect of loan costs works. Any business loan can in theory charge a number of different fees, including:
- Application fees
- Loan origination fees
- Processing fees
- Annual fees
- Administration fees
- Early repayment fees
- Late payment fees
- Closing fees
As fees are so variable between lenders and loan types, it’s very important you understand which (if any) you will be charged when applying for, accepting, managing and closing your business loan. The APR of a loan will include some of the fees named above (the standard fees applicable to everyone), but not all, as repayment fees and penalties can vary from borrower to borrower. This is why you will sometimes see a business loan’s rate stated as an AER (annual equivalent rate). This is the annual compounded rate of interest of a loan, without any fees included at all. Be extra sure when comparing loan costs whether you’re looking at AERs or APRs, and what extra costs you might be liable for.
If you’re considering business financing but want to avoid all of the worries around interest and fees, we can help. Talk to Swiftfund today to understand how a merchant cash advance simplifies the borrowing process.